Today’s snippet reprises Tom Evslin’s great lesson about the economics of networks:

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In 2005, I joined a roundtable held by the venture-capital firm Union Square Ventures in New York to talk about peer production and the creation of open networks and platforms. Counterintuitive lessons swirled around the room as entrepreneurs, investors, and academics analyzed the success of companies built this way. Across the table sat Tom Evslin, the unsung hero of the web who made the internet explode when, as head of AT&T Worldnet, he set pricing for unlimited internet access at a flat $19.95 per month, turning off the ticking clock on internet usage, lowering the cost for users, and addicting us all to the web.

Evslin gave a confounding lesson on networks. Explosive web companies—Skype, eBay, craigslist, Facebook, Amazon, YouTube, Twitter, Flickr, and Google itself—don’t charge users as much as the market will bear. They charge as little as they can bear. That is how they maximize growth and value for everyone in the network. Evslin used an ad network to illustrate the value of building scale in this manner. An ad network that extracts the minimum commission it can afford out of ad sales for member sites will grow larger because more sites will join this network than its greedier competitors. Ad networks need a critical mass of audience before they can sell to top-tier advertisers, which pay higher rates. So charging less commission to grow larger can yield more ad sales at better prices.

It gets even more head-scratching: Evslin argued that if the company that runs the network is too profitable, it will attract competitors that will undercut it and steal market share. “If you’re doing well but running at or close to breakeven,” he explained later on his blog at TomEvslin?.com, “you’ve made it impossible for anybody to undercut you without running at a deficit.” To sum up Evslin’s law of networks: Extract the minimum value from the network so it will grow to maximum size and value—enabling its members to charge more—while keeping costs and margins low to block competitors.

That’s not how many old networks operate. Cable companies wrap their wires around us to squeeze maximum fees out. Ditto for phone companies, newspapers, and retailers. Charging what the market would bear made perfect sense for them. But now they face competition from next-generation networks. Skype—which at the end of 2007 had 276 million accounts in 28 languages—exploded as a free service before it added paid features that drastically undercut old phone companies. Its founders pulled value out of the business when eBay bought it. eBay itself had created a new retail marketplace by extracting little from each sale. Once eBay thought it was alone at the top, though, it started raising fees—but that allowed online retail competitors Amazon and Etsy to steal away merchants.

Evslin’s poster child for network growth is craigslist. It foregoes revenue for most listings in most markets—charging just for job listings and for real estate ads in a few cities—and that made it the marketplace for most listings. “If Craig now attempted to maximize revenue by charging for a substantially higher percentage of ads, a door would be cracked open for competition,” Evslin said. “There is no chance at current rates for a competitor to steal Craig’s listings (and readers) by charging less.” This is the economy in which Google operates. It had no revenue model for its first few years until it happened into advertising. “Bank users, not money,” was Google vice president Marissa Mayer’s advice on building new products and networks. She said in a 2006 talk at Stanford that Google doesn’t worry about business models as it rolls out products. “We worry a lot about whether or not we have users.” That is because on the web, “money follows consumers.”

At the New York roundtable, an entrepreneur quoted legendary Israeli investor Yossi Vardi, who said that when he launched the pioneering instant-messaging service ICQ (later bought by AOL), he cared only about growing. “Revenue was a distraction,” he decreed. This doctrine of growth over revenue was mangled in the web 1.0 bubble, when new companies spent too much of investors’ money on marketing so they’d look big, only to collapse when money ran out and users vanished. Today’s web 2.0 method for growth is to forgo paying for marketing and instead create something so great that users distribute it—it goes viral. Once it’s big, then it can find the revenue. That money may not come directly from users in the form of fees or subscriptions but may come from advertising, ticket sales, merchandise sales, or from the value that is created from what the network learns—data than can be sold. I discuss such side doors for revenue later in the book.

Network economics may be confounding, but networks themselves are simple. They are just connections. You already operate in many networks. Go find the biggest whiteboard you can and draw your networks from various perspectives: First draw your company with all its relationships: customers, suppliers, marketers, regulators, competitors. Now draw a network from your customers’ perspective and see where you fit in. Next draw your personal network inside and outside your company and industry. Draw your own company not as a boxy organizational chart but as a network with its many connections. In each, note where value is exchanged and captured (when you sell, you get revenue; when you talk with customers, you gain knowledge; when you meet counterparts, you make connections). Now examine how these networks can grow, how you can make more connections in each, how each connection can be more valuable for everyone. No longer see yourself as a box with one line up and a few lines down. Instead, put yourself in a cloud of connections that lights up each time a link is made, so the entire cloud keeps getting bigger, denser, and brighter—and more valuable. Then your world starts to look like Google’s.

This is the best extract I’ve seen from the book so far. This really is the difference between companies that have a future on the internet, and those that don’t. To be virtuous on the internet your product(s) needs to be small, numerous, fast, flexible and open. Any one or thing who isn’t all these things is limiting themselves dramatically.

http://blog.threestarleadership.com Wally Bock

In some ways this is a reprise of the favored business strategy of the Eighties, reducing price to gain market share and climb the experience curve faster.

http://www.subhub.com Evan Rudowski

Jeff,

This remains a fundamental strategy; however the world has changed since the conversations you describe from 2005 and 2006. In the current climate many companies do not have the funding to focus solely on scaling. Keeping margins slim means a company must have a margin to begin with. That means profits. In the current climate that means focusing on profit sooner even if it means scaling smaller.

Kind regards,
Evan

http://www.IgorHelpsYouSucceed.com Igor Kheifets

Great post, thanks Jeff!

Rob

Hi Jeff,

This older post is more relevant than ever before.

Smart business owners should use this post to prove to their marketing people that charging what you can – just because you can – is a risky philosophy.

This is an argument I’m currently having with my marketing guy. He thinks my pricing reflects a lack of confidence in myself, my product, and his abilities. The truth is, as CMS systems, and other software become smarter, and closer to free, my tech knowledge becomes less of a necessity and his marketing abilities are much more valuable.

In truth, he could quit me tomorrow, and be the one who puts me out of business next week – If he understood the truths in this article.